Research Review | 9.26.13 | Risk Analysis

Optimal Portfolios for the Long Run
David Blanchett (Morningstar), et al. | Sep 2013
There is surprisingly little agreement among academics about the existence of time diversification, which we define as the anomaly where equities become less risky over longer investment periods. This study provides the most thorough analysis of time diversification conducted, using 113 years of historical data from 20 countries (over 2,000 years of total return data). We construct optimal portfolios for 20 different countries based on varying levels of investor risk aversion and time horizons using both overlapping and distinct historical time periods.
We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion. We also note that the time diversification effect increased throughout the 20th century despite evidence of a declining risk premium. Although time diversification has been criticized as inconsistent with market efficiency, our empirical results suggest that the superior performance of equities over longer time horizons exists across global equity markets and time periods.

Reducing Retirement Risk with a Rising Equity Glide-Path
W. D. Pfau (American College) and M. E. Kitces (Pinnacle Advisory Group) | Sep 2013
This study explores the issue of what is an appropriate default equity glide-path for client portfolios during the retirement phase of the life cycle. We find, surprisingly, that rising equity glide-paths in retirement – where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon – have the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios. This result may appear counter-intuitive from the traditional perspective, which is that equity exposure should decrease throughout retirement as the retiree’s time horizon (and life expectancy) shrinks and mortality looms. Yet the conclusion is actually entirely logical when viewed from the perspective of what scenarios cause a client’s retirement to “fail” in the first place. In scenarios that threaten retirement sustainability – e.g., an extended period of poor returns in the first half of retirement – a declining equity exposure over time will lead the retiree to have the least in stocks if/when the good returns finally show up in the second half of retirement (assuming the entire retirement period does not experience continuing poor returns). With a rising equity glide-path, the retiree is less exposed to losses when most vulnerable in early retirement and the equity exposure is greater by the time subsequent good returns finally show up. In turn, this helps to sustain greater retirement income over the entire time period. Conversely, using a rising equity glide-path in scenarios where equity returns are good early on, the retiree is so far ahead that their subsequent asset allocation choices do not impact the chances to achieve the original retirement goal.
Dynamic Asset Allocation and Tail Risk Monitoring in Turbulent Financial Markets
Benoît Guilleminot (Riskelia), et al. | Aug 2013
The first goal of this paper is to introduce a new financial stress indicator, signaling regime transitions from stability to chaos. This indicator is based on the combination of a wide range of market prices of risk, properly normalized to make them comparable across markets and time periods. After describing the construction and basic properties of the indicator, we illustrate some important applications of the stress indicator for asset allocation and risk management. When the risk aversion signal breaches certain thresholds, risky assets dramatically correlate and their risk rewards deteriorate. We provide simple tactical asset allocation strategies exploiting this behavior. Also, at the onset of chaotic phases, standard risk metrics fail to give an adequate representation of potential losses. As regards systemic risk oversight, a heat map of financial stresses allows regulators to monitor in real time the diffusion of financial fragilities and to take preemptive action when necessary.
Correlation Dynamics and International Diversification Benefits
Peter Christoffersen (University of Toronto), et al. | Jul 2013
Forecasting the evolution of security co-movements is critical for asset pricing and portfolio allocation. Hence, we investigate patterns and trends in correlations over time using weekly returns for developed markets (DMs) and emerging markets (EMs) during the period 1973-2012. We show that it is possible to model co-movements for many countries simultaneously using BEKK, DCC, and DECO models. Empirically, we …find that correlations have significantly trended upward for both DMs and EMs. Based on a time-varying measure of diversification benefit, we …find that it is not possible in a long-only portfolio to circumvent the increasing correlations by adjusting the portfolio weights over time. However, we do find some evidence that adding EMs to a DM-only portfolio increases diversification benefits.
Adaptive Asset Allocation: A Primer
Adam Butler (Macquarie Group), et al. | May 2012
The paper addresses flaws in the traditional application of Modern Portfolio Theory related to Strategic Asset Allocation. Estimates of parameters for portfolio optimization based on long-term observed average values are shown to be inferior to alternative estimates based on observations over much shorter time frames. An Adaptive Asset Allocation portfolio assembly framework is then proposed to coherently integrate portfolio parameters in a way that delivers substantially improved performance relative to SAA over the testing horizon.